Daniel Knowles writes for the Economist about politics and economics and is @dlknowles on Twitter.

Euro breakup would lead to another great depression

Few people remember that the Great Depression didn't really begin with the Wall Street Crash in 1929, at least not for Europe. The far more cataclysmic event was the collapse, in May 1931, of Credit Anstalt, an Austro-Hungarian bank founded by the Rothschild family which simply couldn't survive the sheer number of defaults on its books. As Credit Anstalt collapsed, other banks in Austria followed, and then so too did German banks. The result was a European-wide financial crisis which pushed Britain off the gold standard and most of the rest of the continent into depression.

I bring this up now because it wasn't the financial crisis which did the long-term damage. It was the rise of protectionism in Europe which followed. In Britain, the crisis destroyed the minority Labour government, and with it, the Gladstonian Chancellor Philip Snowden. As a direct result, Stanley Baldwin, the Conservative leader in the new National Coalition, and his Chancellor Neville Chamberlain, finally succeeded in pushing through the tariff plan that had lost them the 1923 election. Simultaneously, Germany, Austria and Italy introduced exchange controls – effectively rationing foreign currency – while France, Belgium and Czechoslovakia built up their own tariff walls in an attempt to protect jobs.

This is why, besides everything else, we should fear a breakup of the euro. If Greece leaves, it will be forced to impose exchange controls and rationing. If it is to import the drugs necessary to run the health service, the oil necessary to run the transport system and the electricity needed to keep the lights on at a price that the government can afford, then foreign currency will have to be rationed. It's happened in Iceland, where everyone who wants to buy foreign currency has to submit an application to a bank, and in Argentina, where the power to buy foreign currency is used as a tool of patronage by the administration. It would inevitably happen in Greece.

And if it happens to Greece, then it could happen to Spain or Italy too. Thankfully, we are still far away from the prospect of either of those countries leaving the euro, but in Spain, the source of the problem is the banking system, not the government – much as it was in Iceland. If no bailout or European-level banking system can be agreed, the temptation to stop foreign creditors from withdrawing money electronically by imposing capital controls would be quite strong. Since most of the world's €500 notes are in Spain, it would probably have to be accompanied by border controls to stop the money leaving physically too.

Quite quickly, the free movement of capital around Europe would be dismantled. Since for goods to move one way, capital must move the other, that would probably lead to a drying up of trade too, as debtor countries engage in import substitutions. And since trade is the main way in which we can all get collectively richer (by specialising in what we're good at), GDP would end up frozen too. Given Europe's demographics, the result would be permanent depression, accompanied by worsening diplomatic relations between countries and chaos within them. Much of the good that free trade within Europe has done over the last 30 years would quickly be undone. The continent would be substantially and permanently poorer.

To think that the euro should never have been created is reasonable. To think that it should be dismantled quickly, and by its weakest members, is a conclusion that can only be drawn from lunatic panic, or crazed ideology. But as Martin Wolf argues, panic is all too rational at the moment:

Before now, I had never really understood how the 1930s could happen. Now I do. All one needs are fragile economies, a rigid monetary regime, intense debate over what must be done, widespread belief that suffering is good, myopic politicians, an inability to co-operate and failure to stay ahead of events.